Here’s a Tip: Buy More TIPS

Energy stocks aren’t the only investment taking a beating from the collapse in oil prices.

Treasury inflation-protected securities have suffered as crude’s 50% decline erodes the chances of a meaningful pickup in the cost of living.

That creates an opportunity for investors who think that inflation is far from dead: TIPS, as the bonds are known, are priced reasonably now.

The interest payments and principal value of TIPS are linked to inflation, rising when the government’s consumer-price index goes up and falling when it goes down.

TIPS are thus often regarded as the ultimate safe asset: backed by the U.S. government, assured of not falling below their original value if held to maturity and built to become more valuable when inflation heats up.

For a TIPS maturing in 10 years, for instance, the “real yield”—or income over time in excess of inflation—is 0.35%. If, over the next 10 years, inflation averages 3%, the average annual return will be about 3.35%. At 2% inflation, the annual return on the TIPS will average 2.35%; at 1%, 1.35%. If inflation goes negative and stays there, you will still get your original investment back in full 10 years from now.

Oil-related energy makes up 5% of the average cost of living, as represented by the consumer-price index. So the 50% fall in the price of oil has cut expected inflation by about 2.5 percentage points. Since the CPI is the measure of inflation to which TIPS are linked, the oil-price plunge has reduced their performance by approximately 2.5 percentage points as well.

Meanwhile, inflation is falling sharply in Europe and slowing in China, making price rises in the U.S. seem even less likely. So TIPS aren’t for anyone who expects to make a fast buck.

Including interest, the broad Barclays U.S. TIPS Index lost 1.8% in the second half of 2014 as oil prices collapsed, while the full Barclays index of Treasurys gained 2.3%. For the full year, TIPS earned 4.4%, half a percentage point behind traditional Treasurys.

Not long ago, investors thought TIPS were tops. After inflation-adjusted bonds earned 11.4% in 2009 while mainstream Treasurys lost 3.6%, investors poured money into them. Total assets at TIPS mutual funds and exchange-traded funds rose to $143.7 billion at year-end 2012 from $90.3 billion at the end of 2009. But then the sluggish economic recovery washed away most worries about inflation. Investors pulled $34.3 billion out of TIPS funds in 2013 and another $2.5 billion last year, estimates fund tracker Morningstar.

Jérémie Banet, portfolio manager of the Pimco Real Return Fund, with $14.1 billion in assets, believes TIPS will outperform conventional Treasurys by a quarter percentage point or more if the Fed doesn’t raise interest rates by more than half a point between now and year-end.

“We expect the TIPS index to return about 4%” over the next year, says Mr. Banet. That might not sound like much. “But it’s better than zero,” he says, “which could be the return on a lot of other assets.”

TIPS are “priced for inflation to remain below 2% for as far as the eye can see,” says Michael Pond, head of global inflation market research at Barclays in New York. “We expect TIPS to do well [relative to other Treasurys] as inflation eventually comes in above that.”

One caveat: TIPS, which were introduced in the U.S. in February 1997, have never been tested in a period of sharply rising interest rates. They would likely drop steeply if interest rates rise without an accompanying jump in inflation.

But the real yield for the TIPS market as a whole has risen to 0.5% from 0.33% at the end of June, as prices remain tame. TIPS tend to do well when their real yield declines. So the recent rise, Mr. Pond says, creates some room for real yields to decline in the future.

TIPS maturing in five years are particularly cheap, he says, if inflation between now and 2020 ends up averaging at least 1.7%.

But the long-term average for inflation in the U.S. is about 3%. And the fall in the price of oil probably won’t last forever, while Uncle Sam will always own a printing press. Whenever the government feels inflation is too low, it can flood the economy with freshly minted money to try driving prices up. That doesn’t work every time—and doesn’t seem to have worked at all in the past few years—but it is almost certain to work over the course of time.

In the minutes released this past week of their deliberations on Dec. 16 and 17, Federal Reserve officials showed their befuddlement over why TIPS prices have fallen so sharply. Investors in TIPS believe that indicates that policy makers at the Fed are intensely focused on driving public expectations of inflation up to the 2% rate that the Fed cites as its own target.

The best time to buy insurance is always when most people don’t seem to think anybody needs it. With the market expecting inflation to stay dormant indefinitely, TIPS are a timely way to protect yourself against the risk that it will rise again.